Markets Fiddle While The World Burns

Hersh Shefrin
, ContributorI write about how psychology impacts financial and economic behaviorOpinions expressed by Forbes Contributors are their own.

Although stocks have continued their irrationally exuberant highs, and the VIX has stayed low, the news these days is worrisome. We know the expression about Nero fiddling while Rome burned. Is the market fiddling, and if so, is it playing Saint-Saëns’ Danse Macabre?

NEW YORK, NY - MARCH 31: Traders applaud on the floor of the New York Stock Exchange (NYSE) as members of the New York Fire Department enter to ring the closing bell, March 31, 2017 in New York City. The Dow Jones industrial index notched its sixth-straight positive quarter, marking the best run for the Dow since 2006. (Drew Angerer/Getty Images)

In Washington, the Trump administration has begun to dismantle the regulations necessary for the U.S. to honor the Paris Agreement, has failed at health care reform, is setting a direction on trade that will weaken the economy, and has provided no evidence that it knows how to govern the country. In the U.K., the British government has initiated the process for Brexit, thereby reigniting the possibility that Scotland will leave the U.K. and that political instability will return to Ireland. Right wing extremism is growing in Europe, and Russia is becoming increasingly assertive, if not aggressive. And then there's the growing nuclear threat from North Korea.

WASHINGTON, DC - MARCH 31: U.S. President Donald Trump speaks about trade as Vice President Mike Pence looks on before signing Executive Orders in the Oval Office of the White House March 31, 2017 in Washington, DC. President Trump signed two executive orders that aim to boost U.S. manufacturing by addressing foreign trade. (Photo by Olivier Douliery-Pool/Getty Images)

A recent Bloomberg article identified the apparent disconnect between the market's frothiness and the news. The authors of that article interviewed me along with others for the article, seeking a plausible explanation for the divergence between the market’s optimism and the public’s pessimism.

The U.S. stock market is irrationally exuberant, according to the value for the P/E ratio developed by economists John Campbell and Robert Shiller. Recent values for P/E have hovered around 28. Although not as high as it was just before the crash of 1929 or the bursting of the dotcom bubble, 28 is historically high; and high values for P/E are unhealthy for future returns.

Campbell and Shiller call their P/E ratio cyclically adjusted P/E, or CAPE. The cyclical adjustment comes from smoothing earnings over a prior ten year window, to mitigate the impact of business cycles. The higher CAPE has been in the past, the lower have subsequent returns tended to be. During the early 1990s, forecasted one-year returns based on CAPE were above 5 percent. During the dotcom bubble, the forecasted one-year return fell to 3 percent, a 40 percent decline. In the leadup to the global financial crisis, the forecasted return was about 4 percent; and once again, it is now below 4 percent.

In regard to the long-term, the forecast of ten-year returns based on CAPE analysis appears to be more ominous. The point forecast for the mean inflation-adjusted annualized return is approximately -7 percent. That kind of decline would be very severe, should it come to pass. The only heartening aspect of such a forecast is that its associated interval forecast is wide, as the standard error of the underlying analysis is about 7 percent. Therefore, a positive ten-year return is still plausible, although high returns are not.

In regard to the long-term, there is much in the news that is gloomy. In the remainder of this blog, I will focus on only one issue, the Trump administration’s move to unleash greenhouse gas production, especially carbon dioxide. The administration argues that allowing more greenhouse gas production will allow for job creation and increased efficiencies. The administration also argues that global warming is a hoax.

From a global warming perspective, the globe is burning. Arctic ice is thinning at an alarming rate. Antarctic ice fields are developing fissures that will lead to enormous icebergs. Only fools now argue that global warming is not taking place. Any remaining controversy among others centers on whether global warming is generated by human activity.